Mortgage Modifications: Help or Hindrance?

Is the mortgage modification program making things worse? An article in the New York Times gives voice to fears that by encouraging homeowners to stay in homes that they cannot really afford, Obama's Making Home Affordable program is actually increasing the agony of homeowners, who pour money down the rat hole of their mortgage rather than recognizing the loss and starting over. In the meantime, the modification programs disguise the true condition of bank balance sheets (because modified mortgages are not yet non-performing mortgages), and slow down the process of recovery.

How much truth is there to this story? Some, at least. I found myself talking to my father about this after I exchanged blog posts over the tragic case of Tom Vellucci, a Floral Park resident who lost his job and wound up with a non-paying tenant, then drained his savings trying to keep up with a modification that got him current, but didn't lower his payment. We're both longtime New Yorkers, so there's a certain local interest in what happened. We were mystified by why anyone would think that Mr. Vellucci would qualify for a modification--and more importantly, why Mr. Vellucci would have thought so.

Reading between the lines in his story, Mr. Vellucci had virtually no savings (making his house payments tapped him out in four months). His income was moderate at the best of times, and his house payment was so large that everything had to go right for him. If he was out of work or lost a tenant for any length of time, he was going to end up in defaulting. As of the story's publication, he was still on the dialysis that cost him his job, meaning he is not going to regain his income any time soon. There was no way that any imaginable mortgage modification was going to clean up this mess. Yet he gave the last of his savings to a skeezy servicer in some sort of tragic Hail Mary pass.

Why would he do something so patently insane? Apparently he was hoping that he could get a second modification under MHA. But his interest rate wasn't his problem. He had a mortgage principal that probably ran into the mid six-figures, and no job, and probably required a modification that slashed his payment in half. The Obama program clearly raised ridiculous, unrealistic hopes in at least a few people.

That said, the people pushing the notion that MHA is making everything worse have their own vested interests: people who want to pin political blame on Barack Obama; hedge fund managers and other financial types who presumably have taken bets that will pay off quicker and easier if foreclosures pick up; people pushing for more aggressive modifications that write down principal as well as interest rates. With few permanent modifications yet approved, and no data, it's not clear to me that this is a significant problem, rather than an occasional tragedy.

But I think that the so far lackluster results from MHA do point to something important, which is that we don't have the kind of mortgage crisis we thought we had when we passed the modification. This represents not only a shift in our thinking about how to fix the housing markets, but a major shift in our national narrative about the housing bubble. Six to nine months ago, the major story we told in connection with the financial crisis was the homeowner suckered--by either fraud or greed--into a teaser loan with an artificially low interest rate that was going to turn disastrous when it reset.

We've seen some of that, to be sure, particularly with the "Option ARM" or "negative amortization" loans on which homeowners weren't even making the full interest payment. But that hasn't turned out to be our biggest problem, largely because we are in a very low interest rate environment right now, so many people saw their rates reset downward rather than up. Instead, we are plagued by negative home equity, and unemployment. We have a modification program designed to avert a threat that never materialized.

Now we have a choice between two more stories. One presents the negative equity as the major problem. Negative home equity is a bigger predictor of default than job loss; so, the reasoning goes, we must be seeing something akin to the infamous "jingle mail", in which people hand over their keys rather than keep making payments on a house that isn't appreciating.

Obviously, this happens. But I doubt it's particularly common. Most bankruptcy experts believe that while there are a handful of grossly irresponsible jerks who deliberately borrow as much as they can get away with before defaulting, or otherwise abuse the process, the majority of people who default try really really hard to find some way to make their payments. (Interestingly/oddly, this does not seem to be as true of student loans and utility bills.)

My story is a little more complicated. People who lose their jobs, but have positive equity, sell the house when money gets tight. (Five years ago, they probably would have refinanced).

People who lose their jobs, but have negative equity, lose the house. So do people who get divorced and have negative equity, people who are whacked with unexpected medical or legal bills and have negative equity, people who get hit with back taxes and have negative equity, people who develop a gambling problem or a drug habit and have negative equity. The negative equity is better correlated--but that doesn't mean that people are deciding to walk away from houses just because they're underwater.

My story is kinder to the debtors, but it also makes modifications more problematic. If the negative equity is the main problem, you can solve the mortgage crisis by switching to modifications with "cramdowns"--i.e., get a judge or a banker to write off the portion of the principal that exceeds what the house is worth. This has unpleasant side effects--it would probably pretty much instantly return us to the days of 20+% down payments on every house, and likely cause house prices to fall farther. But it at least has some hope of solving the immediate foreclosure problem.

But if negative equity is merely exacerbating an untenable situation, it's not clear how much good even a cramdown will do. Proponents of cramdowns have begun a recent love affair with the pre-1977 bankruptcy code. They are blissfully oblivious to the fact that the pre-1977 code was in many ways much less debtor-friendly, which is why it was reformed. But that is neither here nor there, really. Even the pre-1977 code did not view the cramdown as a sort of magical gift to the homeowner.

At least as I understand it, cramdowns were then, as they are now, part of a Chapter 13 bankruptcy--in other words, part of a court-ordered repayment plan, not a Chapter 7, in which the debtor sheds their past debts. If a Chapter 7 debtor wants to keep an asset that is securing a loan, he has to reaffirm the debt.

In a Chapter 13 cramdown, the loan is "stripped" or bifurcated into two portions: the secured part, in the amount of the asset's current value, and an unsecured part, which is paid after other obligations have been satisfied. (In practice, this usually means "never"; they're generally discharged if the plan is completed successfully). You have to pay the bank on time, every month, for a number of years; if you don't, your Chapter 13 fails, and the loan reverts to its old terms. Which, among other things, means that you now owe all the money you didn't pay the bank while the modification was in effect, plus the interest that compounded on the unpaid portion. Since most Chapter 13 plans fail, this should give advocates of mortgage cramdowns pause.

There is no precedent or procedure that I am aware of for letting homeowners get a modification in order to sell the house; that's what a short sale is for. But if people really are defaulting out of desperation, then selling the house is probably what they need to do. Unless they're very poor, people don't lose the house because they got a 5-10% pay cut; lower taxes mitigate some of the effect, and people will do a lot before they'll allow themselves to be foreclosed on. No, by the time most people are looking at foreclosure, they're in one of three situations:

They were irresponsible borrowers who have amassed an essentially unpayable amount of debt.

They have had a dramatic loss of income (business failure, bad investments, furlough/job loss/new job at lower pay).

They have had a dramatic increase in expenses (lawsuit, medical bills, back taxes, gambling problem, etc.).

The first group may be helpable, but if someone has $50,000 in credit card debt, no responsible banker would agree to modify their loan outside of a bankruptcy court; you'd essentially be making a free gift to other creditors who ought to share the pain.

The second group is not helpable, because outside of a few frothy markets like California, writing the house down to market value will not provide enough of a decrease to cushion the kinds of income decline that push people into foreclosure. A 10% write-down on a $400,000 mortgage at 6.25% nets you a little over $250 a month in savings. If you make enough money to have a $400,000 mortgage, you are not defaulting because you suddenly developed a $250 shortfall in your monthly budget.

This arithmetic is also a problem for the third group, plus one hopes that no sensible banker would modify the loan of anyone whose other major creditor was Harrah's.

So to answer the question I posed at the beginning: there's not much evidence that the current scheme of mortgage modification is making things worse. But there's also not much evidence that any differently designed system would have made things any better. We may have to look for other ways to ease the pain of those whose houses are more than they can afford.

And we might start by trying to make it easier to get out of houses, as well as stay in them. Instead of encouraging people to throw their savings into hopeless modifications, maybe the government should be trying to streamline the process of arranging for a short sale so that people can walk away with a little savings in the bank (and on their credit report) to help them get a fresh start.

Update: A reader at Atlantic Business argues that an MHA directive does this. It's a good start, but I'm thinking more like a requirement that banks accept short sales where the payment is more than 40% of current income, and the offer is within 5-10% of the appraised value of the house or the most recent tax assessment, without forcing the homeowner to first become delinquent.

I mean, not anything that hamfisted--but some set of relatively clear guidelines for which it is fairly simple to document the criteria.

Banks and servicers are in no position to do anything complicated quickly--I'm sure many of them are dragging their feet on modifications and short sales, but it's also really quite clear that they're genuinely overwhelmed by the volume that has flooded them. You can order them to process short sale offers in 10 days, but that doesn't mean they can develop the institutional capacity to do so within anything like the necessary time frame.

I'm sure at least one reader will protest that this is a giveaway to deadbeats, and a violation of property rights, but it's more like an orderly process for recognizing the inevitable. The terms I specified are quite generous to the banks, because someone in that position is quite likely to default eventually. Setting transparent general terms for a short sale saves the banks administrative costs, not to mention the much higher costs they'll pay if the home goes to foreclosure.